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A Long-Short Value Investing Strategy

Backtesting a Fundamental Investment Approach in the German, Austrian, and Swiss Markets

1. Executive Summary

The European Value Fund (EVF) employs a long-short value investment strategy, targeting undervalued stocks with strong fundamentals while shorting overvalued stocks based on book-to-market ratios. This approach exploits market inefficiencies and behavioral biases, generating excess returns through a disciplined factor investing framework.
 

Since 1992, EVF has delivered an annualized return of 10.59%, outperforming the benchmark’s 8.86%. By systematically adjusting for size, value, and momentum factors, the strategy ensures risk-adjusted returns while mitigating exposure to broader market fluctuations.

10.59%

Annualized returns

12.8%

CAGR

0.86

Sharpe Ratio

-20%

Max Drawdown

0.0076

Information Ratio

0.0092

CAPM alpha

Portfolio Performance Over Time

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2. Introduction

The European Value Fund is designed to capitalize on the historical outperformance of value stocks relative to growth stocks. The fund operates within Germany, Austria, and Switzerland, focusing on stocks in the top 10% book-to-market ratio while shorting the bottom 10%.

 

This strategy is rooted in the Fama-French High Minus Low (HML) factor, which captures the excess returns of high book-to-market stocks over low book-to-market stocks. Empirical research has consistently shown that value stocks tend to outperform growth stocks over long time horizons, providing a robust rationale for this strategy.

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By leveraging monthly rebalancing, EVF continuously adapts to market conditions while preserving its systematic value tilt. This ensures exposure to mispriced securities, offering a superior risk-return tradeoff.

Key questions explored

  • How does a long-short value strategy generate alpha?

  • What role do factor exposures play in explaining returns?

  • How does EVF compare to traditional long-only value funds?

Skills demonstrated

R programming language

Backtesting and benchmarking

Risk and Performance evaluation

Portfolio optimization

Factor investing

3. Factor Exposure and Portfolio Returns

The fund’s risk-adjusted performance is driven by exposures to key asset pricing factors:

  • Value (HML): Strong overweight in high book-to-market stocks

  • Size (SMB): Small-cap bias due to systematic undervaluation

  • Market (MktRF): Moderate correlation with broad market trends

  • Momentum (WML): Minimal exposure, limiting short-term price drift risks

These factors collectively explain excess returns, ensuring persistent outperformance across economic cycles.

Factor Loadings

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4. Performance Analysis: Risk vs. Reward

The European Value Fund (EVF) demonstrates strong performance across different market cycles, particularly excelling during market corrections where value stocks tend to recover from undervaluation. The strategy performed exceptionally well in the aftermath of the 2008-2009 financial crisis, taking advantage of deeply undervalued quality stocks that rebounded as market conditions stabilized.​

Drawdown over time for HML Constructed

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Market Peaks and Valleys: Historical Context

  • 2008-2009: Strong outperformance post-financial crisis as value stocks rebounded.

  • 2014-2016: Period of underperformance due to sharp oil price declines affecting energy-heavy value stocks.

  • 2020 COVID-19 Crash: Initial underperformance, but sharp recovery as market volatility corrected valuation disparities.

Risk Mitigation Strategies

Volatility Heatmap (Annualized)

  • 2008 Financial Crisis: The darkest blue regions highlight extreme market volatility, particularly in the MktRF (market risk premium) factor, reflecting the severe turbulence during the global financial meltdown.

  • Early 2000s Dot-Com Crash: Increased volatility in the HML factor suggests that value stocks experienced heightened risk exposure, likely due to the dramatic rotation away from overvalued tech stocks.

  • Post-2010 Stabilization: A visible decline in volatility post-2010 across most factors indicates a more stable market environment, though periodic spikes remain.

5. Conclusion: Does EVF Deliver Superior Value Investing Returns?

Yes. The long-short value strategy effectively captures the value premium, delivering consistent alpha over time. With a Sharpe ratio of 0.78, robust factor exposures, and a disciplined rebalancing framework, EVF remains a strong performer in value investing.

However, investors must be aware of:

  • Increased turnover costs due to frequent trading.

  • Short-selling constraints, especially in low-liquidity environments.

  • Potential factor underperformance, particularly during growth-driven bull markets.

Ultimately, EVF’s evidence-based, systematic approach ensures its long-term viability, making it a compelling case for factor-driven value investing.

Investment Universe & Data

  • Time horizon: 1992 - 2020

  • Markets: Switzerland, Austria, and Germany

  • Stock Selection: Top 10% (long) and bottom 10% (short) based on book-to-market ratio

  • Rebalancing Frequency: Monthly rebalancing with transaction cost of 0.1% of tradevalue

  • Data Source: Historical stock and factor data from European Fama-French database

  • Factor Data: Market, Size, Value, and Momentum

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